Topic: ETFs

Simple Investment Options: High-Quality Stocks and Passively Managed ETFs

High quality companies and traditional ETFs can serve as simple investment options with lower risk.

Here’s a general rule that forms a key element of the Successful Investor approach to buying stocks: A simple investment is better. The easier an investment is to explain and understand, the less likely it is to harbour hidden risks and costs that can only work against you. As the old investor saying goes, “Stick with plain vanilla.”

For the investment industry, the rule works in reverse: The more complicated, the better. Each new feature provides a profit opportunity for the institution that sponsors the investment. It’s particularly important to keep this in mind with ETFs.

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Simple investment strategies for lowering risk

For safer investing, adhere to our Successful Investor philosophy by focusing on investing in high-quality stocks that offer hidden value. As you likely know, we stress what we call “hidden assets”—assets that are easy to overlook, since their full value rarely appears on a company’s financial statements.

These assets include long-time real estate holdings that are worth much more than their balance-sheet value (usually original cost minus depreciation). Under-used brand names are another good example. When they are developed in-house, they won’t show any balance-sheet value. Another key hidden asset we favour is research spending. Companies write off their research outlays in the year in which they spend the money, but benefits such as new or better products may only materialize years into the future.

A simple investment strategy should avoid focusing solely on one or two indicators because that can lead to increased risk

When they choose stocks, many investors zero in on one, or at best, a handful of indicators. This deviation from our Successful Investor approach can do more harm than good. For instance, many investing newcomers get the idea that you should only buy stocks that trade at a below-average p/e ratio (the ratio of a stock’s price to its per-share earnings).

This, however, ensures that you will avoid some stocks at precisely the best time to buy, or buy others that you should avoid.

A lower p/e may make the stock seem like a safer buy, but by the time the p/e comes down to attractive levels, the stock may have already doubled or quadrupled. If you focus strictly on p/e’s, you will miss out on that rise.

Another problem with focusing on low-p/e stocks is that many disasters-in-waiting go through a low-p/e period prior to their eventual collapse. This low-p/e period occurs because individuals close to or involved with the company recognize that it has serious problems. They sell their own holdings and they tell their friends and relations to do the same.

To get the best possible value out of p/e’s, at TSI Network we look at them in the context of everything else that’s going on in the market and with individual stocks.

Well-established companies are the key to profitable and low risk investments

Instead of moving between extremes of risk, we continue to think investors will profit most—and with the least risk—by buying shares of well-established companies that have strong business prospects and strong positions in healthy industries.

That’s not to say that there won’t be surprises that affect every company in a particular industry. But well-established, safety-conscious stocks have the asset size and the financial clout—including sound balance sheets and strong cash flow—to weather market downturns or changing industry conditions.

We still feel that investors will profit the most with a well-balanced portfolio of high-quality individual stocks that follows our Successful Investor approach. But ETFs can also play a role in a portfolio: here are some tips on how to find the best performing ETFs.

When are ETFs a great example of a simple investment?

Traditional ETFs are like highly efficient mutual funds. Fees are low because investors don’t pay for active management. Instead, traditional ETFs aim to mimic the performance of a market index, by holding the same securities in the same proportions used to calculate the market index. As a liquidity feature, ETFs generally sell newly created units whenever their unit prices develop a premium (usually slight) over the value of the stocks they hold. They buy back units (in large blocks only, to keep costs low) when the unit price gets too far below the value of their holdings.

Adding features and hedges to ETFs makes them more complex and more costly

Adding more features (sometimes referred to as “wrinkles” or “bells & whistles”) can make investing in ETFs attractive to a wider range of investors. As TSI Network has often warned subscribers, adding features also adds profit opportunities for the sponsoring institution.

For example, one sales pitch is that you can profit from growth in the stock market of an emerging economy, and avoid foreign-exchange risk, when the ETF operator hedges against movements in that currency. This conveniently overlooks the fact that hedging costs money.

Hedging costs will vary, depending on conditions in the foreign-exchange market, and on how an ETF carries out its hedging program. These fees can double or triple the typical 0.30% to 0.70% ETF management fee.

You’ll need to dig deep to find out how much you pay for an ETF’s hedging feature. But you can be quite certain that the placing of each new hedge provides a profit opportunity for the ETF sponsor.

Our view: simple is better. If you buy an ETF, choose a “plain vanilla”, unhedged version.

What are some simple investment strategies you use while picking stocks?

In your opinion, what are the best benefits of sticking with “simple” investments?


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